401(k) vs. IRA: What’s The Difference?

It's time to invest, but you're not sure what type of retirement account is right for you. Perhaps you've heard your employer talk about a 401(k), but have also heard about something called an IRA. The 401(k) vs. IRA – what's the difference?

Let's define each term to help you figure out what's the best investment for you.

The IRA (Individual Retirement Arrangement)

An Individual Retirement Arrangement is a form of retirement plan that gives investors (like you) certain tax advantages for retirement savings. Note that IRAs are also called “Individual Retirement Accounts,” but the term “Arrangement” is more appropriate.

An IRA can contain a number of different stocks, bonds, or mutual funds; the mix is up to you. This is the same as a 401(k) which we'll get to later.

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Here are two of the most popular types of IRAs:

1. The Traditional IRA

When people refer to their IRA, they're typically talking about a traditional IRA. The great thing about a Traditional IRA is that contributions are tax-deductible, meaning you won't pay any taxes on your contributions. This is a great option if you desperately need the money you would normally pay in taxes for other types of contributions. However, you do have to pay taxes on withdrawals at retirement.

2. The Roth IRA

Contributions made into a Roth IRA are already taxed, but you won't have to pay taxes on withdrawals at retirement. This offers a mathematical advantage over the Traditional IRA, as your money grows tax-free! This type of IRA is highly recommended.

Other IRAs

There are a number of other IRAs available but are seldom discussed. Here are a few of them:

SEP IRA – For small businesses to contribute funds into their employee's Traditional IRA.

SIMPLE IRA – This type of IRA requires the employer to match contributions to the plan whenever an employee makes a contribution. This is actually remarkably similar to the 401(k), but it does have lower contribution limits.

For more information on funding an IRA and more, see Publication 590 produced by the IRS.

The 401(k)

Like the IRA, a 401(k) is also a type of retirement savings account. Within the 401(k) can be a number of different investments, such as stocks, bonds, or mutual funds.

There are different types of 401(k)s just like the IRA:

1. The Traditional 401(k)

One major difference between the 401(k) and most other IRAs is the fact that employers are to match a certain amount of the contribution their employees make into the account. Businesses offer 401(k)s at their discretion for the benefit of their employees.

Traditional 401(k)s allow you to make tax-deductible contributions, but you'll have to pay taxes on withdrawals at retirement.

2. The Roth 401(k)

This type of 401(k) is very exciting. Here are a few facts about the Roth 401(k):

You pay taxes on your contributions, but your investments grow tax-free and you can withdraw funds at retirement without paying any more taxes! This has a huge mathematical advantage, just like the Roth IRA.

You still get a contributing match from your employer (like the traditional 401(k)).

Some businesses (such as corporations) are now offering the Roth 401(k), and if your employer offers it, by all means take it!

Another nice aspect of the 401(k) is that at this time it allows a higher rate of contribution. See 401(k) contribution rates for more information.

Here's an interesting article talking about the pros and cons of a Roth 401(k) from Walter Updegrave of Money Magazine. Some of the highlights: Let's…

Last Edited: 24th April 2012 The content of biblemoneymatters.com is for general information purposes only and does not constitute professional advice. Visitors to biblemoneymatters.com should not act upon the content or information without first seeking appropriate professional advice. In accordance with the latest FTC guidelines, we declare that we have a financial relationship with every company mentioned on this site.

About John Frainee

John Frainee is a personal finance writer at TheChristianDollar.com. His goal is to provide biblical financial principles that encourage people to live healthier lives. Beyond personal finance, John enjoys spending time with his wife and two crazy cats, playing a competitive game of Monopoly, and reading just about anything he can get his hands on. You can also find him on Twitter and Facebook.

I was wondering if you knew what happens if you quit your job and go back to school. Do you just leave everything in the 401k? I’m planning to leave everything in my roth IRA and have that sit there as my e-fund (and so I still get a leg up on saving for retirement) but what happens with my 401k? I just let it sit there too right?

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